Friday, November 30, 2012

US bank reserves at the Fed grew about $27bn, with the "other" category showing up in reserves this week (as Lee Adler discussed earlier). Overall the pace of reserves growth is still quite modest on a relative basis (currently reserves are at the level of early September.) Further increases are expected in December as more MBS purchases settle.

Bank reserves (source: FBR)

Moreover, the Fed's balance sheet unexpectedly shrunk by $20bn this week. Part of the decline has to do with MBS paydown from all the mortgage refinancing activity. Certainly there is some noise in the balance sheet measures and reserves on a week-to-week basis, but the Fed is definitely being cautious. We may see a more aggressive approach to bank reserve expansion after Operation Twist (see discussion) winds down - likely early next year. There is about $50bn of short-term notes left to sell (chart below).

$bn

A number of economists continue to argue that increasing bank reserves is not productive at this point in the cycle because it will not stimulate further credit expansion (while risking inflation).

Spain's large temp labor force (see discussion) should help reduce unemployment quickly, once recovery takes hold. But given the sorry state of the banking system (see post), when do economists actually expect Spain's economy to begin growing again? The latest forecast from Goldman shows that it will be some three years before even a modest real GDP growth should be expected.

Purple = forecast (source: GS)

What's amazing is that earlier this year many mainstream economists were projecting a "short and shallow" recession (see discussion). In fact economists have been consistently lowering their forecasts all year. The chart below from Goldman shows the consecutive worsening of the 2013 forecast for Spain's GDP growth.

Source: GS

Given Spain's limited ability to grow its debt levels (simply because the market and the EMU will not let them), the debt to GDP ratio is expected to level off just under 100% on a gross basis. And simply for reference (and many people will take issue with this comparison), the US is already at 100% debt to GDP on a gross basis.

China's retail investors have lost all confidence in the nation's stock market. In spite of improving economic fundamentals (see discussion), the market continues to plunge. Unlike many other emerging markets, China's domestic stock market trading is dominated by retail investors. And many feel they have been duped, as the market hits new lows.

JPMorgan: - Of the households with stock market investments, 77% had not made a profit. The stock market has
been the worst performing asset class over the last 5 years from various investment instruments
available to the retail investor. If a retail investor put Rmb100 into the CSI300 5 years ago and left it, it
would only be worth roughly Rmb 47 today...

Shanghai Stock Exchange Composite Index (source: Yahoo Finance)

China's brokers have spent the last few years hyping the market, with a positive projections each new year. And each year retail investors have been disappointed. Now some are waiting for the government to effectively "bail out" the equity market before they would feel comfortable getting in.

WSJ: - “Local retail investors have lost faith on the stock market over the past three years. How can we expect investors to rush into a market where all expectations for a bottom, say the 3000 and the 2000 level, have proven to be wrong?” said Amy Lin, analyst at Capital Securities.

“The market is likely to stay weak until the government launches significant market-friendly measures, such as more stock buybacks of listed companies and another cut in banks’ reserve requirement ratio,” she said.

Many of China's retail investors simply left the stock market altogether, preferring property and gold instead.

FT: - The domestic Chinese investors who dominate trading in Shanghai have had plenty of bad news to weigh up over the past couple of years. China’s economy has slowed for seven straight quarters and is on track to record its lowest annual rate of growth for a decade this year. There are concerns, too, that the political paralysis surrounding the country’s once-a-decade leadership transition has delayed needed reforms.

Indeed, many Chinese investors have simply given up on equities and moved to other investments such as property, gold or high-yield wealth management products.

The percentage of dormant brokerage accounts has been rising.

Source: JPMorgan

In a market with a more diversified investor pool, one would see this retail capitulation as a bullish sign. But there are very few active institutional players in China's domestic market (although the government has been trying to change that by increasing foreign investment quotas.) For now it will take either retail investors coming back or a government action to turn it around. And given the change of the guard in China's leadership, it may take them some time to organize a decisive action. For institutions who do have access to China's domestic market however, this may be a good time to start testing the waters.

Thursday, November 29, 2012

Is the US government ready for another bailout? This time it's the US Postal Service, which is quickly headed for bankruptcy. Technology simply passed them by - faster than anyone had expected. For example a large percentage of US teens these days don't even know how to write a "snail mail" letter and where to put the return address, etc.

Clearly the USPS has been trying to keep up with the changes by upgrading its offerings (like same day delivery) and its technology. It has also been shrinking its workforce. In fact according to the U.S. Bureau of Labor Statistics, we now have fewer postal employees than any time since the late 60s.

CBS: - Changes are coming to U.S.P.S. offices and staffing in the coming year. Donahoe said about half of the nation's post offices are "changing." "We're in the process of doing something called The POST Plan. We have 26,000 post offices across the country. We're changing about 13,000 -- half of them to part-time hours. That keeps them open, keeps the town's identity. The zip code, no change there. But we can do a lot more efficiently, there's no reason to have a place open eight hours a day if you have an hour's worth of business."

By the end of 2013 the workforce will also have to be reduced. "We have reduced our workforce by 280,000 people over the last 10 years, 35 percent," Donahoe said. "We're in the process right now this year of another 40,000. Our people do a tremendous job. They are very efficient."

Source: U.S. Bureau of Labor Statistics

But losses continue to mount.

TwoCircles.net: - The US Postal Service (USPS), which predates the US itself, is careening toward bankruptcy in the wake of a record $15.9 billion loss this year that has ignited fierce debate over the government's role in preserving an iconic American institution.

"What we're facing now is our own fiscal cliff," US Postmaster General Patrick Donahoe said in televised comments Wednesday.

Donahoe implored Congress to pass legislation by the end of the year that would help it free up capital and bolster its entrepreneurial flexibility.

"If they act now, we'll get this whole thing behind us and we can be profitable and then focus on growing the postal business," he said.

The travails faced by the agency underscore a deep ideological divide in the United States over the role of government.

Conservative-minded critics - including Republican lawmakers - call the agency an unwieldy, inefficient behemoth incapable of competing with private couriers like FedEx and United Parcel Service (UPS). American taxpayers, they say, should not act as a fiscal backstop if it can't survive on the open market.

Supporters, meanwhile, say the agency was set up to fail thanks to a 2006 law requiring it to prefund retiree health benefits 75 years into the future-to the tune of $5.5 billion annually for 10 years. No government agencies or private-sector businesses are forced into such onerous terms, they say.

Here are some basic facts about the USPS (from USPS):

1. The government agency has been completely self sufficient with no taxpayer support - until now.
2. They service 150 million residences, businesses, and PO boxes.
3. USPS has 26,000 retail locations (down from 32,000?).
4. Annual revenue is $67 billion (expenses of course are higher).
5. USPS delivers 40% of world's mail.
6. As a private enterprise it would rank #29 in Fortune 500 (Deutsche Bundespost was privatized in 1995, is it too late for USPS?).
7. USPS.com is the most popular website among the federal government websites (time for advertising?).
8. Apparently it is ranked "the most trusted government agency" - which doesn't say much, but certainly helps.

Closing USPS down suddenly will create a massive disruption. Something will need to be done (fiscally or legislatively) to keep the agency afloat - at least until a longer-term solution can be found.

The media has given a great deal of attention to Spain's extraordinarily high unemployment rate, which has exceeded that of the US during the Great Depression (see post). But how did Spain get from 8% unemployment in 2008 to 25% now?

Source: Tradingeconomics.com

The latest work from the NY Fed shows that two factors made Spain's labor force different from the rest of the Eurozone (including Greece).

1. Before the financial crisis almost 13% of Spain's labor force was in construction. That compares to roughly 8% in the Eurozone and under 6% in the US. The housing bubble and regional infrastructure "pet projects" (funded by cheap sovereign and regional debt financing) in Spain provided a great deal of support to the labor market. Just as a reference point, the US lost 29% of total construction jobs from the peak (45% of residential construction jobs). If the US had double the percentage of jobs in construction as Spain did, the results would have been devastating.

2. Spain had a uniquely large temp labor force, with some 32% of employees working under a temporary contract in 2007. Europe as a whole was half that. That allowed companies in Spain to quickly reduce staff by cutting temporary employees (a great deal of the temp employment was actually in construction). The layoffs provided Spanish firms with flexibility but also contributed to a much more rapid reduction in labor force than elsewhere in Europe.

Source: NY Fed

The hope is that Spain's labor force "flexibility", due to the nation's large temp labor force, should work well in recovery, as firms feel more comfortable taking on temp staffing.

NY Fed: - Spain’s employment experience relative to the rest of the euro area illustrates the cost to the economy of firms having such a high level of flexibility in how they manage workers. Going forward, the hope is that the benefits of such a flexible labor market will also become apparent as firms are quick to hire once the economy starts to make a meaningful recovery.

It may be a while however before we see signs of recovery, particularly given the poor state of the banking system (see story from Reuters).

US natural gas sold of sharply in recent days, driven mostly by warmer weather forecasts.

Bloomberg: - Gas dropped as much as 3.8 percent as forecasters including MDA Weather Services predicted above-normal temperatures for most of the lower 48 states over the next 10 days. Unusually cold weather helped reduce a supply glut this month. The December contract expires today.

“The weather is moderating so it’s wearing a little bit on the market,” said Tom Saal, senior vice president of energy trading at INTL Hencorp Futures LLC in Miami. “We’ve got an expiring contract today, that could be part of it.”

Jan Henry Hub gas contract (source: barchart)

The declines however should be limited due to reduced nuclear power generation. A large number of nuclear plants have been down unexpectedly and it may take time to bring them online. US nuclear generation is materially below normal for this time of the year, which should provide a floor to natural gas prices.

Wednesday, November 28, 2012

Who is buying this paper? The Greek government of course (plus those who bought these bonds for speculation). The idea is for the government to buy debt at a discount and "retire" it, reducing the indebtedness level by the amount of the discount.

NY Times: - The troika has calculated that if successful, the debt buyback, together with other means of debt relief, could help Greece reduce its debt to 124 percent of gross domestic product in 2020 and even further after that, from about 175 percent now.

But the current holders, knowing this information, may try holding back to see if they can get a better price, now that there is a big buyer in town. Plus those who have not marked this debt to market (which apparently is the case for some Greek banks) will realize a loss upon sale and may not be eager to sell right now.

NY Times: - a number of hurdles remain that could mean delays in reducing Greece’s debt. For one, Athens will also have to persuade bondholders to sell back their debt at a price that is attractive to the government. Bondholders will hold out for as much as they can get.

In addition, some of those bondholders are beleaguered Greek banks. The government bonds they hold count as bank capital and pay a high rate of interest, reflecting the risk attached to the debt. Writing down the value of the bonds, and forgoing that capital and income, will eventually leave the banks even worse off than they are now. That may require the troika to send even more aid to Greece in the future to recapitalize the banks, analysts say.

As it is, nearly 85 percent of the coming installment of bailout aid has been set aside to shore up Greek banks, which have virtually stopped lending.

Obviously Greece will be doing this debt buyback with borrowed money - using a loan that is in addition to the money the Eurozone leaders agreed to release this week.

NY Times: - The loans needed to carry out the buyback would come on top of the money that European officials and the I.M.F. committed to release after marathon talks in Brussels this week.

And if the government can't buy enough of these bonds, there is always Plan "B".

NY Times: - Mr. Stournaras said that if the program failed to attract sufficient interest from the banks and insurers that hold the government’s debt, officials had drawn up a “Plan B.” He refused to elaborate.

As discussed earlier the housing shadow inventory is in part being fed by re-defaults on modified mortgages. One of the comments we got (h/t rjs0) was that the recent spike in re-defaults (see post) may have been caused by the release of iPhone5 (impulsive borrowers would forgo mortgage payments to buy a new phone). That's a frightening thought (and an amazing achievement for Apple).

The larger picture however points to a decline in shadow inventory in 2013. JPMorgan anticipates 650K of re-defaults (could be worse if Apple comes up with a new popular product) and 1.2 million of new delinquencies. At the same time existing delinquencies are working their way through the "python" (see post from a year ago) - modifications, short sales, and liquidiations. The forecast is a net 380K reduction.

The ISI Group combined four US regional Fed indices with Markit Manufacturing PMI to create a comprehensive US manufacturing index (chart below). A pattern of growth starts followed by fairly sharp corrections emerges. Some have speculated that this volatility, at least in part, can be explained by the Eurozone uncertainty flare-ups: Greece (2010), Italy (2011), Spain (2012). The pattern also exists in the economic surprise indices (see post-1 and post-2).

Source: ISI Group

What's particularly concerning is that subsequent recovery has not been as strong as the previous "cycle". Businesses are becoming increasingly skeptical about spurts of growth. A similar pattern can also be seen in the ISM Business Confidence measure.

Source: Tradingeconomics.com

Anecdotal evidence suggests that the current "cycle" will not go into its full upswing until there is clarity with respect to the US fiscal situation. But already some are talking about a strong first quarter of 2013 induced by Hurricane Sandy reconstruction expenditures - and then possibly another dip next summer, repeating the pattern once again. In the long run, this volatility in confidence is highly undesirable because it inhibits capital investment and hiring, forcing corporations to sit on cash (or pay cash out in dividends).

As discussed before (see post), Japan's fundamentals have been working against the yen. Political pressure on BOJ (see discussion) and weak economic conditions are likely to result in a highly accommodative monetary policy. Even under the current government, the latest QE program has been accelerated (which is bad news for the yen). The chart below shows JGB purchases specifically as part of the latest monetary expansion (isolated from other JGB holdings).

Source: BOJ

The yen, which to a large extent no longer acts as a "safe haven" currency (see discussion) has been losing ground (as an example, over the past month both the yen and the S&P500 are down).

JPY (per one dollar)

There is no question the fundamentals point to further yen weakness. Technical factors however may be indicating that JPY is becoming a crowded short. The Goldman sentiment index (which is based on speculative futures positioning) has shifted against the dollar (in yen's favor).

Source: GS

GS: - Our JPY Sentiment Index took another dive after recovering somewhat in the last report; it now stands at 12.8 and is close to exhibiting signs of stretched short positioning (SI below 10). After some reductions in the prior week, traders again built sizeable short positions in JPY, with short JPY positioning increasing by almost 50% ($3.9bn) from the last report.

Therefore in spite of these bearish yen fundamentals, one needs to become more cautious being short the yen due to technical headwinds. The unwind of the crowded short could prove painful.

Tuesday, November 27, 2012

We've had a number of e-mails asking about the difference between the FNMA bond coupon and the actual mortgage rates (see discussion). The financing costs that the US government (the GSEs) pays is of course lower than the mortgage rate charged to the consumer. Much of that difference is from the so-called g-fees. Since the government effectively guarantees mortgages funded via the GSEs, it needs to get paid for that guarantee. In the past g-fees were significantly underpriced relative to the private sector. That was part of the reason for the housing bubble - the financing was artificially cheap. It was also the reason the GSEs' government bailout was so expensive - Fannie and Freddie didn't charge enough for the risk they took (and didn't reserve enough capital).

That's about to change. The only way to shift at least some of the mortgage business to the private sector (currently the GSEs and the FHA own or guarantee over 90% of the US mortgage market) is to price the risk closer to where it would be priced in the private sector. Otherwise the private sector will never enter this market - other than to sell the mortgages banks originate to the government and keep the origination fees (which is what banks do now).

The taxpayer also needs to recoup the Fannie and Freddie rescue expenses. That means the GSEs will need to raise their g-fees, which according to JPMorgan is exactly what they plan to do (chart below).

Source: JPMorgan

G-fees should be at the level that would allow a bank to achieve a reasonable return on regulatory capital (under Basel III) when holding mortgages on balance sheet to maturity/prepayment. According to JPMorgan, that fee should be in a 71-95bp range for standard mortgages in order to achieve a 15-20% ROE. Of course raising g-fees is not always the most beneficial action from the political perspective. And some politicians are going to put up a fight:

Equities.com: - United States Senators Robert Menendez (D-NJ), Frank R. Lautenberg (D-NJ), Chuck Schumer (D-NY), Kirsten Gillibrand (D-NY), Richard Blumenthal (D-CT), Joseph Lieberman (I-CT), and Bill Nelson (D-FL) called on Acting Federal Housing Finance Agency (FHFA) Director Ed Demarco to abandon a proposal to increase the guarantee fees ("g-fees") on loans guaranteed by Fannie Mae and Freddie Mac in five states, warning it is unfair to states with strong consumer protection laws and will increase the cost of homeownership. FHFA's proposed rule would hike g-fees beginning January 1, 2013 in New Jersey, New York, Connecticut, Florida and Illinois.

In a letter to DeMarco [included here], the Senators argued that the agency's proposal would unfairly penalize homeowners in the five states that better protect consumers from lending and foreclosure abuses: "The main reason cited by FHFA for its proposed rule, is that state and local policies designed to protect homeowners from improper lending and foreclosure practices and that reduce the likelihood of future defaults, have increased the financial costs faced by the GSEs. However, in its effort to recoup the foreclosure-related costs faced by the GSEs in the short-term, FHFA is creating undue barriers that could undermine vital consumer protections and restrain residential lending."

Keeping g-fees low is fine of course, as long as the US government plans to continue dominating the mortgage market. But if that's not the long-term plan and the GSEs' influence should be reduced, g-fees will need to go up.

Monday, November 26, 2012

A couple of weeks ago the IEA announced that Iran's oil exports have spiked to 1.3 million barrels per day (mbpd) in October from 1 mbpd in the summer. The explanation seems to be increased purchases from Asia.

Reuters: - The IEA said Iranian oil output rose by around 70,000 barrels per day (bpd) to 2.7 million bpd in October [from 2.63 million barrels per day in September]. Iranian exports jumped to 1.3 million bpd from 1.0 million seen in the two previous months.

"China and South Korea appear to account for the lion's share of the increase in Iranian imports," the IEA said in its monthly report.

The jump in imports could have brought Iran an additional $900 million last month, according to Reuters calculations based on the price for its oil of $100 a barrel.

Iran has been able to rename and "re-flag" its cargo ships multiple times to get around the sanctions. Some cargoes exchange and blend crude directly from ship to ship off the coast of Malaysia - with non-Iranian ships then headed for destinations "unknown".

But as discussed earlier, China wants to develop a more reliable source of crude, which will be coming via a pipeline from Russia (see post). The Russian crude oil pipeline will open up a whole new market (ESPO) in the Sea of Japan. This is expected to reduce demand for Iranian crude.

Possibly in response to these dynamics, Iran all of a sudden announced today that it will cut exports back to the low levels of the summer: 1 mbpd in 2013 (vs. 1.3 mbpd from the latest IEA number).

FARS: - "Apparently, the government wants to decrease the 1392 [note that in the Solar Hijri calendar, year 1392 starts March 21, 2013] state budget's reliance on oil exports to one million barrels a day," member of the parliament's Budget Planning Commission Gholamreza Mesbahi Moqaddam told FNA on Monday.

He said that the parliament is not concerned about deficiency in the 1392 state budget due to the western oil sanctions for the country sees crude embargos as an opportunity to reduce or even cut the country's reliance on oil exports.

The official explanation of course is Iran's desire to reduce dependence on crude exports. It's a step in the right direction, but that's something the nation should have initiated years ago rather than during this crisis (see discussion). The announcement constitutes a change in direction and took some market participants by surprise. Also if production is reduced for a prolonged period, it may impair long-term output capacity. Brent futures however have not responded. Some traders are saying that this is a bluff in an attempt to boost oil prices or the market is simply well supplied even if this reduction in output is real.

Brent July 2013 contract (source: barchart)

What is true is that Iran has a limited storage capacity for excess oil, which may explain some of the need to cut output. Iranian TV reported big plans to build new storage capacity.

Reuters: - With exports down sharply and fewer oil tankers available to store the excess, Iran's Press TV reported on Sunday that Iran plans to build millions of barrels of additional storage facilities in the Gulf over the next few months.

"By the middle of the next year, nearly 8.1 million barrels will be added to the crude oil storage capacity of Iran," Press TV reported the managing director of the Iranian Offshore Oil Company (IOOC), Mahmoud Zirakchian-Zadeh, as saying.

These developments are important to watch going forward because crude oil and petrochemicals exports are Iran's lifeline to obtain hard currency. With its economy in distress, access to hard currency will be increasingly important in order to satisfy the population's most basic needs.

It is clear that Greece will need some form of debt restructuring, and the Eurozone leadership seems to be committed to getting that done (see discussion). Given the lack of cohesion, the Eurozone may just need a bit of a push from the markets in order to reach a consensus. But many still believe that not only will Greece need restructuring, but it will also exit the EMU as soon as next year. Citi research for example has assigned a 60% probability to "grexit".

This probability figure feels quite high - particularly given that Germany seems to be committed to keeping Greece in (because they fear the "domino effect"). In spite of these forecasts, the prediction markets seem to be saying something very different. The latest Intrade odds for "grexit" by the end of 2013 are close to half the figure from Citi.

Any country currently using the Euro to announce intention to drop it before midnight ET 31 Dec 2013

Those who believe Citi's forecast should be buying this contract right now. So far however those who bet on this event seem to prefer selling the contract.

US mortgage prepayment speeds have accelerated to the highest level since 2004 recently.

Source: JPMorgan

Most assume that this is all coming from recent mortgages with low loan-to-value ratios. As rates decline, those who took out a mortgage in 2010 for example are now refinancing it. But there is a bit more to the story. If one looks for example at the 5%, 30-year FNMA pool (these are loans paying roughly 5.5% interest on average), a different picture emerges. The pre-2009 "vintage" mortgage prepayment speed for these high coupon mortgages is higher. The chart below shows CPR (prepayment rate) by mortgage origination year.

What's going on here? The answer has to do with the Home Affordable Refinance Program (HARP). It's a little venture run by the US Treasury and HUD. HARP was set up to help borrowers who are current on their payments but with homes that have dropped in value so much that it makes them ineligible for bank refinancing. The FHA has its own version of HARP as well. Here are the requirements (from HARP):

The mortgage must be owned or guaranteed by Freddie Mac or Fannie Mae.

The mortgage must have been sold to Fannie Mae or Freddie Mac on or before May 31, 2009.

The mortgage cannot have been refinanced under HARP previously unless it is a Fannie Mae loan that was refinanced under HARP from March-May, 2009.

The current loan-to-value (LTV) ratio must be greater than 80% ["under water" mortgage ineligible for standard financing].

The borrower must be current on the mortgage at the time of the refinance, with a good payment history in the past 12 months.

So that's how 2009 cutoff comes into the picture. Those who took out a 5.5% mortgage (for example) after 2009 and could refinance, already did - that's why the refi speed after 2009 for these mortgages is lower. But those in the pre-2009 bucket are refinancing via HARP. According to JPMorgan, under the second HARP program, a million borrowers have refinanced their mortgages in 10 months. The program is expected to be in place until the end of 2013. The combination of HARP and the Fed's MBS purchases keeping rates low, mortgage refinancing is expected to stay elevated next year. And of course mortgage originators should do quite well in this environment. In fact banks are boosting staff levels to deal with the refi wave.

JPMorgan: - Sustained by HARP 2.0, and then QE3, [the refi wave] is
poised to last well into 2013 and eclipse the
prior record in duration, though not in
magnitude. Extended periods of low rates
compel originators to expand mortgage banking
capacity to take advantage of the business
opportunities.

Bank reserve deposits normally decrease when the Treasury’s balances at the Fed rise as the money the Treasury takes in from taxes and debt sales is withdrawn from bank accounts, which in turn causes bank reserve balances at the Fed to fall. Then, in the next week or two, the Treasury spends that money and the resulting deposits are reflected in increased reserves at the Fed. That increase also represents the creation of economic credits that show up in the economic data for that week. When the Treasury sucks up cash as it does when it collects quarterly taxes or sells new debt, the economy slows for a few days, but when the checks go out, things pick up again. You can see the resulting weekly fluctuations clearly in a wide variety of unadjusted banking and money supply indicators.

Reserves also increase when the Fed settles the paper it buys from the Primary Dealers, offset by the Treasuries the dealers sell to the Fed. With the settlements of QE3 purchases now under way, reserves will begin to increase dramatically in the weeks where there are large settlements. Last week and this week are the first of those. The next week of MBS purchase settlements will be the week of December 12.

The Treasury deposited a net of $2.9 billion to its checking account at the Fed last week as the dollar amount of its revenues and net new debt sales were almost balanced by its outlays. This brought its deposit balance to near $27 billion in the week ended Wednesday.

Partly as a result, bank reserve deposits declined by $4.5 billion.

The mysterious “Other” depositors, however, added $31 billion to their accounts at the Fed. Ding-Ding-Ding and flashing lights, I think we now know what at least some the “Other” deposits are. They appear to be the Primary Dealer accounts used in their trades with the Fed’s SOMA. On November 14 the Fed settled some $36 billion in MBS purchases from the Primary Dealers. The dealers didn’t need to settle their Treasury purchases from the previous week until the following day, after the closing of the weekly Fed H41 statement, causing the cash in their accounts to bulge that day.

The next big round of MBS settlements will be in the week of December 12-20- over $70 billion. We should see a big jump in reserves in subsequent weeks.

Sunday, November 25, 2012

Australian mining investment growth has been tremendous in the past couple of years, with current financial year inflow of some 7% of the GDP. Companies like Fortescue have tapped the hot US junk bond market to pump cash into mining operations. At the same time non-mining investment has been declining, making Australia's economy more vulnerable to a downturn in demand for raw materials.

Source: Merrill Lynch

But the party is about to end. In spite of China's recent mild economic rebound (see discussion), infrastructure spending is not going to generate the demand for iron ore and coal that it used to. Mining firms need to shift their focus. What makes it particularly painful for Australian mines however is their high costs relative to the competition. Mining labor costs have grown at over 4% per year since 2009. And as other nations with large mining sectors have seen their currencies devalued, the Australian dollar has remained relatively strong - making Australian
product more expensive.

Source: Merrill Lynch

With investment in Australia's mining sector slowing, the nation will need to transition to other sources of growth. To help with the transition, the RBA is likely to lower rates again in December.

Merrill Lynch (Australia): - ... in our view the case for further easing isn't substantially data dependent.
Rather, it is based on the need to nurture alternative sources of
economic growth as the mining investment boom approaches its peak, and a
recognition that – in the face of the substantial ‘headwinds’ confronting those
alternative sources of growth (such as the persistent strength of the A$,
depressed business confidence, and ongoing fiscal consolidation) – further
support from monetary policy is likely to be needed in order to ensure that this
‘baton change’ in the drivers of growth happens smoothly.

The Fed's latest securities purchases are still not having much of an impact on bank reserves (see discussion). The net effect of Fed's recent activities is equivalent to sterilization, although this is probably not what the central bank had intended. The result is similar to the ECB's SMP (Securities Markets Programme), which was (usually) sterilized by auctioning off term deposits (securities purchases increase reserves, while term deposits "drain" them).

$bn; Source: FRB

Without the increase in bank reserves, the US monetary base has been stable (unlike during previous balance sheet expansion programs). So far the Fed's securities purchases have not translated into quantitative easing (no "money printing" just yet).

We are starting to see early signs of business activity stabilization in China. Two leading indicators are particularly helpful:

1. The November HSBC/Markit flash PMI went into expansion territory for the first time in over a year.

Hongbin Qu, Chief Economist at HSBC: -
“As November’s flash reading of HSBC manufacturing PMI bounced back to the expansionary territory for the first time in 13 months, this confirms that the economic recovery continues to gain momentum towards the year end. However, it is still the early stage of recovery and global economic growth remains fragile. This calls for a continuation of policy easing to strengthen the recovery.”

Source: HSBC/Markit

2. The November MNI China Business Survey recovered sharply, particularly on a seasonally adjusted basis - as adjusted by the ISI Group (chart below). Just as an aside, the ISI Group continues to do great work on China economic research - thanks guys!

Source: The ISI Group

These latest figures seem to indicate that a "hard landing" in China has been avoided, at least for now. If the trend continues, both China and the US should provide some support to global growth.

Saturday, November 24, 2012

Argentina CDS spread has blown out to new highs last week. In spite of Argentina's government driving the nation's economy into the ground (see discussion), this widening was caused by increased risks of the so-called "technical default" rather than deteriorating economic conditions.

Argentina sovereign CDS (source: JPMorgan)

For years, bond holders of Argentina's government debt (issued under NY law), who did not participate in Argentina's restructuring plan from the 2001 default, have been fighting to be treated equally (pro rata) with those who had accepted the restructuring terms. But Argentina has insisted that that those who did not play ball in their restructuring plan - the "holdouts" - should get nothing. Last week however a US judge gave Argentina a Thanksgiving surprise by ruling in favor of the holdouts. That means the holdouts will need to be paid everything that the restructuring participants got over the years, including all the interest.

JPMorgan: - Last Wednesday, District Judge Griesa issued his decision in
the pari passu ruling ahead of Thanksgiving ... in favor of holdout creditors. Griesa
defined a pro rata payment formula that requires full upfront
payment by Argentina to holdouts of US$1.3 billion...

The judge told Argentina's lawyers that the nation needs to put $1.3 billion into escrow by December 15th, pending the Appeals Court’s ruling. If Argentina fails to do so and the country's appeals process in the US is exhausted, the sovereign CDS will be triggered.

JPMorgan: - A potential refusal by Argentina to comply with an adverse
ruling would threaten “technical” default on 2005 and 2010
restructured claims (92% of total debt defaulted in 2001). This
would occur if US courts considered the remedy (pro rata
payments) adequate and equitable.

Based on Argentine government's belligerent behavior toward the rest of the world (see discussion), the odds of the $1.3bn showing up in the escrow account next month are not great. That, combined with the Appeals Court (as well as whatever other appeals Argentina can come up with - possibly appealing to the US Supreme Court) agreeing with Judge Griesa, will put the nation into default - again. By the way, those who still don't think Argentina's government is acting like thugs toward foreigners, just read this story from the Mail.

The market-implied peso exchange rate (the so-called "shadow" exchange rate - see discussion) now puts the peso at 42.3% discount to the official rate as the currency continues to decline. Should the technical default take place, the US will begin freezing Argentine government's dollar accounts - which will push the shadow exchange rate to new lows.

Under pressure from the IMF, the Eurozone leadership is desperately looking for ways to restructure the Greek government debt in a politically "acceptable" way. The IMF has been calling for some form of relief that would put Greece on a more sustainable path. The troika forecasts for Greek recovery in the past have been nothing more than exercises in self deception (see chart from Marc to Market). Realistic estimates put Greek debt at double the GDP some time in 2014 unless there is a restructuring. The IMF charter simply prohibits the fund from providing support to nations without at least some reasonable expectation (even an optimistic one) of recovery.

Lowering rates and extending maturities seems to be the most palatable solution so far.

Businessweek: - “I have preferences and that means no fresh money because it is difficult to explain to our taxpayers,” Austrian Finance Minister Maria Fekter said. She predicted a “mixed package” that could include lower rates, though countries with higher borrowing costs like Spain and Italy would want compensation for any losses on lending to Greece.

And that's one of the places the situation gets sticky. Italy and Spain say they are not in a position to take losses, even if these losses do not involve loss of principal. While funding Greek bonds, Italy and Spain would be paying more in their own borrowing costs than they would receive from the reduced Greek debt coupon. These nations are now pressuring Germany to compensate them for whatever "Greek pain" they may endure.

GS: - German government may be asked to compensate other governments for additional Greek financial support. Reducing interest payments for the Greek government would be one way to narrow the funding gap that has opened up. Lower rates, however, would imply that some governments, notably the Italian and Spanish governments, would have to pay higher rates in funding the Greek help than what they receive in interest payments from the Greek government. One solution, according to press reports, would be that the German government compensates these governments, to some extent at least, for the interest spread. It is not clear whether such a solution would be acceptable to the German government. But it suggests that some difficult questions still need to be answered before the next tranche can be paid out.

It is difficult to imagine the German government telling its citizens that not only is it easing the terms of Greek debt, but the taxpayers are also compensating Italy and Spain (and possibly other nations) for their share of losses. The Greek restructuring numbers are actually relatively small, particularly compared to Germany's government budget. But it is not as much about the numbers as it is about politics. With less than a year before the next general election in Germany, a Greek solution is critically important. At the same time the solution German voters would prefer can not involve additional taxpayer resources (or at least perceived as such).

So the Eurozone leadership continues to dig for other sources of funds. Everything seems to be on the table, including raiding the profits made by the Eurosystem (the ECB and NCBs) on Greek debt. There is even talk of the ECB returning future interest payments on the Greek bonds it holds back to Greece. This is unlikely to be sufficient, but is certainly easier to sell to the voters.

Businessweek: - Finance ministers are also considering how to tap profits made by the ECB and national central banks on Greek bonds, drawing on a February commitment to recycle that money back to Greece. The question of how to treat future ECB profits also has to be addressed.

In spite of dire economic conditions, Greece actually stands a good chance of turning its economy around if the debt burden is reduced (see discussion). The Eurozone has to find a restructuring solution if Greece is to be part of the EMU going forward. And Germany may need to step up once again. As of today, Angela Merkel seems optimistic: “I believe there are chances, one doesn't know for sure, but there are chances to get a solution on Monday...” This should make for an interesting weekend in the euro-land.

Friday, November 23, 2012

After a strong rally in late summer, Egypt's stock market has been on a steady decline. First, the correction has been driven by the recent tensions surrounding Israel and Hamas. Hamas jihadist groups have close ties with militants in the Egyptian Sinai and enjoy support throughout Egypt. If Israel were to take further military action, it could destabilize the region. But recently another alarming development has put pressure on Egypt's equity markets.

WSJ: -
The Egyptian revolution took another bad turn Thursday, as President Mohamed Morsi gave himself dictatorial powers over the legislature and courts. The world has feared that the Muslim Brotherhood would favor one-man, one-vote, once, and the Morsi coup is an ominous sign.

"The people wanted me to be the guardian of these steps in this phase," Reuters quoted Mr. Morsi as saying on Friday. "I don't like and don't want—and there is no need—to use exceptional measures. But those who are trying to gnaw the bones of the nation" must be "held accountable."

Nations with no history of democracy and lacking strong democratic institutions often end up in such situations. People forget that the ability to elect one's leader is only a step in building a democratic state (after all, Adolph Hitler was also democratically elected). In many cases people simply elect another dictator - which seems to be the situation in Egypt currently. Of course with food prices elevated, it doesn't take much to spark widespread social unrest.

Protesters run from riot police during clashes at Tahrir square in Cairo (Source: Ahram Online)

In spite of being a promising emerging market and touted by some as a new post-Arab-Spring opportunity, Egypt has taken a turn for the worse.

Source: Yahoo Finance

As is often the case, Western leadership and intelligence sources remain one step behind the events in the Middle East.

WSJ: - Mr. Morsi's coup is also awkward for the Obama Administration, which had been praising the Egyptian in media backgrounders for his role in brokering the cease-fire between Israel and Hamas. Mr. Morsi was hailed as a moderate statesman. Yet Secretary of State Hillary Clinton had barely left Cairo before Mr. Morsi made his move. He may have figured that all the praise made it easier for him to grab more power.

In a style typical of such regimes, the government is making an attempt to stabilize business conditions and buy time by injecting government capital into the economy. The money will be effectively used as a bribe but the effect is likely to be quite temporary in nature.

Egyptian Government (official statement): - Prime Minister Dr. Hisham Qandeel said the government will pump in almost EGP 276 billion ($45bn) in investments at the business sector, and economic organizations with the participation of the private sector in the plan of the fiscal year 2012/2013.

The plan aimed at increasing growth rates and creasing more job opportunities.

The Prime Minister gave the statement during his meeting with the committee in charge of investments map which was attended by Investment Minister and representatives of finance, industry and domestic trade ministries.

Qandeel discussed means to attract more investments and foreign and Arab capital and Egyptians abroad investments.

With Egypt's implicit support for Hamas (an organization that has little interest in economic stability) and more civil unrest on the way, the hopes for near-term market recovery have now been dashed.

The DAX and other global equity indices continued to rally today, helped in part by the latest IFO business survey from Germany.

For the first time in months the IFO survey (see discussion) saw an improvement - in both the current situation and in the expectations of future conditions.

The Ifo Institute: - The Ifo Business Climate Index for German industry and trade rose again after six successive decreases. Companies expressed slightly greater satisfaction with their current business situation. They were also far less pessimistic about future business developments. The German economy is holding up in the face of the euro crisis.

In manufacturing the business climate index rose slightly following a six-month decline. Companies expressed slightly greater satisfaction with their current business situation. They were also less pessimistic than last month with regard to the six-month business outlook. Export expectations were positive for the first time in three months.

The business climate index in wholesaling increased sharply. The wholesalers surveyed reported a dramatic improvement in their current business situation and expressed far less pessimism regarding future developments. The business climate also brightened in retailing. While assessments of the current business situation were somewhat poorer, retailers expect business to pick up significantly in the future.

In construction the business climate recovered considerably. Construction companies reported a clear improvement in their current business situation and were also more confident about future business developments.

Another business survey, the Markit Germany PMI indicator, came in flat, but the numbers were better than the expectations.

Source: Markit

Germany Markit PMI (Source: Econoday)

WSJ: - The economic tide may be turning in Germany. After six consecutive declines, the widely watched Ifo Business Climate index rose in November, defying economists' predictions of a continued fall.

For Europe's biggest economy, the global picture, and in particular the performance of the U.S. and China, looks more important than the euro-zone crisis. With global growth less fragile, Germany's exports engine, itself one of the engines of the euro-zone economy, can fire up again.

The improvement in the Ifo index was broad. Manufacturers, construction firms, wholesalers and retailers were all more confident both about their current situation and, in particular, their expectations for the future. While service-sector sentiment declined, this tends to lag turns in manufacturing confidence.

The Ifo data corroborate a similarly unexpected rise this week in the Markit purchasing managers' index for Germany, which also showed improvement in manufacturing.

It is important to note that on the whole these latest indicators still point to an ongoing contraction in Germany's business sector expectations. The chart below plots the path of current vs. expected conditions - and Germany is still in the "Downswing" quadrant (headed toward "Recession").

However the pace of the contraction is lower than the recent market expectations and may be pointing to an inflection in Germany's economic activity. The surveys' trend in the next couple of months should confirm if this stabilization is indeed real.

US small business optimism continues to improve gradually, but still remains at recessionary levels. One of the big problems for small businesses remains the uncertainty in future economic conditions. 23% of survey respondents say they have no clue what to expect from the economy going forward. That's the highest level of uncertainty since the Jimmy Carter administration (see video below). And as discussed earlier (see post), uncertainty can materially inhibit economic growth.

Credit conditions don't seem to be a problem in part due to the lack of demand. With uncertainty at such high levels, the last thing a number of small businesses want to do is increase debt levels.

Weak sales are the number one single issue cited in the survey, but regulation and taxes are still a major concern for US small business - which of course contributes to more uncertainty.

DB: - Together, government requirements and taxes are cited by 39% of small
businesses as their biggest problem among the eight remaining components.
While this is down from 42% in September, it is clearly an elevated reading that
likely needs to fall substantially further for small business confidence to ultimately
trend higher.

Source: DB

Just to put things in perspective, small businesses represent half the private GDP and half the private workforce in the US (see video below). That explains in part the anemic economic growth in the US over the last several years.

Thursday, November 22, 2012

Some may find this a bit surprising. The magnitude of losses experienced by hedge funds on average during the height of the Eurozone crisis in 2011 was as large as the losses the industry witnessed during the financial crisis in 2008.

But unlike the performance after the financial crisis, the industry has been unable to shake the 2011 losses. Since the 2011 shock, hedge funds have been trending sideways for over a year now. Managers continue to find it extremely difficult to position themselves in response to the Eurozone madness. Many became short the various risk markets (or went into cash) this past summer and got hurt by Draghi's action in late July (see discussion).

Numerous funds got involved in sovereign CDS - long protection - and took losses as CDS tightened (see discussion). Being short going into QE3 did not help either. Also a number of equity funds got hurt by a sharp sell-off in technology recently. The declines in commodities and emerging markets earlier in the year caused some funds to underperform as well.

The groups that did well have been some of the more specialized managers such as the Nile Pan Africa Fund (up 35% YTD) or DAFNA Lifescience (up 49%). But with yields at historical lows and macro risks still lurking, generating consistent returns (after high fees) has became extraordinarily tough for the industry as a whole.

Everyone is talking about European finance ministers failing to reach an agreement on Greek funding. There is another meeting scheduled for Monday. It is clear that a Greek exit, which many observers had thought was inevitable six months ago, is not in the cards.

Instead, what is being debated is how to fund Greece, which we continue to note is not really about aiding Greece as much as ensuring the country's ability to service its debt, which is primarily in official hands. Still that does not stop some officials from proposing to give the private sector another haircut through the buy back of government bonds at a 50 cents or so on the euro. Anticipation of some buy back may be helping to drive Greek bonds higher today.

However, perhaps the most important take away from the failed talks was that it appears to have spurred a tactical shift by Germany. Shortly after talks ended, Germany indicated that it is open to providing new financing for the euro zone's EFSF lending capacity and accept lower interest rates on existing loans. It seems more determined than it has been in making sure that the Athens' program remains intact. The new funds would ostensibly be used by buy back Greek bonds.

To be sure though, increasing the EFSF lending capacity does not necessarily cost German a single cent. Despite cries from some quarters about German reluctance to give more funds to Greece, the fact of the matter is that the EFSF works on the basis of guarantees, not money from the creditor nations. The EFSF funds are raised by the sale of bonds to investors, not by transfers from German tax payers.

While there may be opposition to new guarantees, most recognize it is preferable to the alternative that the IMF is pushing for which is an official sector haircut.

The media continues to report that a key remaining hurdle is debt sustainability. The issue is whether Greece should have another two years, to 2022 to bring its debt/GDP ratio down to 120%. That is what the European finance minister seem to favor. The IMF insists on 2020.

These numbers are arbitrary. Why is 120% debt to GDP sustainable, but not 125%? Moreover, the debt/GDP ratio is just as much about the denominator as the numerator. The IMF has done a spectacularly poor job in forecasting Greek GDP. Given the margin of error, there is, statistically speaking, no real difference between the IMF and European finance ministers positions. To be filed under "the hubris of small differences".

Germany's tactical shift underscores another point we have made. Some observers have argued that Germany should consider leaving the monetary union. There is no sign that this is being considered and quite to the contrary, Germany is willing to make some concessions to ensure that monetary union is sustained. Simply put, EMU is in Germany's interest. Leaving EMU would cost Germany. The hard won competitive gains of German producers would be quickly eroded by competitive devaluations. It would leave Germany isolated, which is abhors and it would be blamed for wrecking Europe...again.